A springtime boost for Europe

Asset allocation strategy
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5/3/2017

In light of Europe’s strengthening recovery, several factors have led us to review our allocation choices.

Unchartered european waters ahead

The European recovery is still intact and the latest surveys suggest growth could be running at about 3%. It is striking to see that the IFO survey, which is closely correlated with German GDP growth, has revisited previous peaks. The two biggest laggards, France and Italy, were seeing little growth up to the autumn of 2016 but have now caught up with the others. Unlike last year when the economic upturn had not yet been reflected in company earnings, profits are now up sharply. Earnings for 2017 are expected to rise by close to 15%. Although the European recovery has been taking shape for months, there have been net outflows from European equities since February 2016 when investors first started to take Brexit risks seriously.

Markets began to worry about France’s presidential elections and the mounting tide of populism when Donald Trump won the US presidential race. First round election results in Austria and the Netherlands suggest France’s anti-European candidate will be defeated. That would really clear the political air in Europe as Germany’s elections are risk-free, judging from the opinion polls. True, Italy’s parliamentary elections will be tricky but they will probably be held at some time in 2018.

We are convinced that we now have the right conditions for European equities to catch up significantly with US equities if the second round opinion polls for the French presidential election are accurate and Emmanuel Macron wins.

Many non-European investors have stayed clear of Europe even if fundamentals have turned positive. That is why we have once again increased European equity weightings in our portfolios. We have also upped subordinated financial bonds by cutting exposure to investment grade credit.

Key points

Overweight European and Japanese equities

Increased exposure to convertibles

Highly overweight financial debt

Is the reflation trade over? Not so fast!

The reflation-sensitive assets which outperformed the most from Donald Trump’s election have since wiped out some of their gains. The new president’s political setbacks over healthcare reform have given the impression that the administration will be unable to follow through on key electoral promises. And inflation in leading countries seems to have slowed a little while wage pressures remain just as strong. The initial euphoria has given way to doubt, probably excessively so.

Donald Trump’s election effectively buoyed reflation hopes but they had already been at work since last year, spreading throughout the world after starting in China. And the Chinese movement is still intact. The new US administration may well seem to be struggling with its stimulus plans but it is hardly likely to give up completely. Rather, it could return to the fray with fresh initiatives. Global growth is now synchronised and expected to be higher than its potential. This means it is on a reflationary trend and there are thus tangible reasons for investor scepticism on reflation to fade.

We are also tactically upping exposure to Japanese equities, which have significantly underperformed since the beginning of 2017, as well as convertible bonds. Lastly, we have returned to neutral on the US dollar. Markets have already more or less discounted likely Fed action in the future. But in this catch-up phase, we cannot rule out other leading central banks gradually moving to tighten their still highly expansionist monetary policy.